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Jim O'Neill began his career as a currency analyst in London, and quickly became widely followed for his prescient calls on the yen and the euro, first at Swiss Bank Corp., and then at Goldman Sachs, where he headed global economics, commodities and strategy research. The Manchester, England, native coined the term BRICs (for Brazil, Russia, India, China), helping pave the way for the popularity of emerging markets with global investors. Now chairman of Goldman Sachs Asset Management, London, O'Neill today refers to such countries as "growth markets"—the subject of his forthcoming book, The Growth Map: Economic Opportunity in the BRICs and Beyond. He spoke last week about wobbly European markets, the charms of the growth markets, and what he expects for stocks.

Barron's: What form do you see the euro taking here?

O'Neill: We need either fewer members or more integration. This isn't a credit crisis, but a crisis about the structure and leadership of EMU [European Monetary Union]. Like a marriage, you can only tell how strong it is when something goes wrong. Countries got in despite the Maastricht Treaty criteria, and the rules of the growth and stability pact haven't worked. They need more true union to bring it closer to the United States of Europe, as such, or it won't survive. It's not easy, because, obviously, they aren't the same sovereign state, and individuals don't vote on it. An interesting twist was that the Christian Democratic Union in Germany is happy in principle to support countries leaving.

There will not be any definite voluntary choices. Greece and Portugal might look most odd inside the EMU, but how would you take them out without the markets' significantly pricing in the probability of all Club Med countries going out? I'm not sure that without Italy there would be any EMU. Italy has a very weak part, primarily the South, but a pretty good part, the North, which can compete with much of Germany and France.

"In my opinion, the bull market in equities started in '09, post-crisis, because of two things: the BRICs and Fed monetary policy." —Jim O'Neill
Goldman Sachs

What do you make of Italy's new premier and measures to restore stability? Do they draw a line under the market?

I know Mario Monti very well. I am on the board of Bruegel [a European economics think tank], and Mario was the first chairperson. As a technocrat, of all the people they could have chosen, he is the best. And he is very pro-European. But can an unelected person actually lead the country into supporting tough choices? What I see is another missed opportunity for the European Central Bank to act more aggressively to support the Italian bond market today. The ECB should be doing more conventional quantitative easing [QE]. It needs to intervene more aggressively in the heart of Europe. It's great the ECB has independence and is, in principle, protective of it. Without EMU, there's no independence to protect. A striking example of getting in front of a crisis was demonstrated by the Swiss National Bank in August. Their intervention in the Swiss franc, or their statement saying that they would use unlimited resources, was masterful. The franc reversed 20%, and, of course, they've hardly spent anything. And it amazes me that the ECB doesn't have the same clarity of purpose. If the Italian bond market carries on the way it does, the bank problems people worry about will get worse. The Fed, for example, wouldn't just sit there being all principled.

What are the odds that EMU survives?

In five years' time, EMU will still exist. With Italy in it. But it's going to be one hell of a rocky road. Italy is a large country in the heart of Europe, and the northern part of Italy is as competitive as virtually anywhere else. You couldn't have had EMU without Italy, because German companies insisted it had to be in EMU.

How is an investor supposed to make money in Europe?

You invest in the most highly rated governments, of which Germany is at the core. The more intriguing aspect is the equity side. In the past fortnight, the European market and the global equity market have become a lot less sensitized to the European problems. Equities are quite cheap. You have to look forward a bit, and, assuming what I said was right and there will be some solution and EMU survives, European equities will recover sharply.

You really need to see a Greek default. Greece can't survive the challenges and more austerity without a major default. That might happen before the end of the first quarter. I am not sure they exit EMU. I think a Greek default is manageable. And I don't think a Portuguese default is inevitable. The Argentinean situation [Argentina devalued the peso and defaulted on its debt in 2002] is a familiar guide. It went on for the best part of two years. People worried about contagion. What actually happened is everything rallied, in particular Brazil, and of course Argentine equities did as well.

I am Mr. BRIC. It transformed my professional life. The creation of the BRIC club by the political leaders is something I never expected. I should add that they have yet to invite me to one of their meetings. The whole idea of individual BRIC funds was a surprise.

But BRICs weren't enough.

I came up with the term "growth markets" a year ago, because of my new job as chairman of the asset-management division. I was shocked at how conservative and cautious about the world pension funds are, and people still think of emerging markets as some kind of disease, despite the popularity of the phrase BRIC. It's just so wrong. The whole purpose of introducing the term was to help 5,000 people at GSAM [Goldman Sachs Asset Management], and through that, all our clients, start to understand how the world is changing.

The eight countries in the growth markets are the four BRICs, and, in addition, Indonesia, Korea, Mexico and Turkey. They are each 1% or more of global gross domestic product. That is the definition of a growth market. In the current decade, their combined GDP will rise by $16 trillion, about double that of the U.S. and euro area put together. Why do people call them emerging markets when they are driving the world economy? That's why I call them growth markets. You can't think of emerging markets the same way people did in the past.

In terms of GDP per capita, some really are emerging.

Obviously, they're not the same as the G-7, because of the wealth factor. But some are not far off. Korea is $20,000 a head these days; Brazil is $15,000. If you wait until they get as wealthy as the G-7, the investment opportunity will have gone. If these countries get to the wealth of the G-7, they will for the next decade turn out to be the best investments to have.

Aren't they affected by the European crisis? How about banks funding project management?

Plenty of other financial institutions and private-equity guys should be regarding this as an opportunity. The most important place to the growth markets and the rest of the world is China. What happens to China depends on inflation. There is strong recent evidence that Chinese authorities have eased up on some controls on domestic bank lending, particularly to small institutions. That is obviously critical for China, which dominates anything going on in the growth market. Turkey is the most vulnerable to the European banking problems. But this is a North Atlantic crisis, not a global crisis.

What do you expect for Chinese growth?

In the next 12 months, the dollar value of the four BRIC economies will increase $2 trillion. That will create another Italy, and that wouldn't happen if those countries' inflation rates kept rising. The most important news recently was the Chinese CPI [consumer-price index]. It is very interesting that the Chinese stock market had another good rally. If China can't get inflation back down to 4% by the first quarter, then sustaining growth of between 7% and 8% or more would become increasingly difficult. Their problem this year has not been the European debt crisis. The fact that inflation appears to be turning in a number of these places is obviously good news. Oddly, the European crisis is a bonus, because it helped bring commodity prices down.

So China has engineered a soft landing?

It's a little premature to be overly convinced, but the past month's evidence strongly supports it. Next month's inflation alone could easily drop by another full percentage point. So inflation is going back below 5% next month. If what I have just said happens by the middle of next month, Chinese equities will already have rallied quite a bit further.

What about the rest of the world?

Europe is already in a recession. Despite that, I think we are going to get growth globally next year of close to 4%. I'm coming up to the end of my 30th year in this business, and over that period, growth has been 3.6%. If global growth is close to 4%, it confirms that Europe doesn't drive the world economy or world markets. In my opinion, the bull market in equities started in '09, post-crisis, because of two things: The BRICs and Fed monetary policy, and so you got the world growing close to 4%. If the world grows close to 4% next year because of China and the BRICs and growth markets, and the Fed stays really friendly, you will need constant bad news to stop equities going up.

Will the Fed find QE3 necessary?

The U.S. economy is doing better than many people assumed in July and August. Look at the recent jobless claims, a pretty good indicator for much of my career. I think the U.S. economy will grow between 2% and 3%, and in the event of some initiative on housing, which seems distinctly possible, the U.S. economy might start growing above trend again, above 3%.

What is such a wonderfully pleasant contrast to the narrow-mindedness in Europe is that the Fed is so clear in its bias that, in the event of the economy weakening back to what it showed briefly in July, the Fed would go back to QE3. But I am not sure there's any need. It's quite conceivable, just to confirm how strong their bias is, that it might go to some kind of nominal GDP target of effectively 4.5% or 5%—an inflation target of 2%, with GDP of 3%. That will be very powerful for markets. I'd say that in the next six months, there's a 50% chance they'll adopt it.

Let's go back to stocks.

Valuations look very cheap, whether developed or growth or emerging. Of course, it's a sign of how pessimistic everybody is. I love to follow the one-year forward P/E [price/earnings], because it guides where the market is driving. The U.S. is at less than 12. Every single European market is single-digit. China is less than 10. The only ones that don't look really cheap are India and Indonesia. An even more conservative approach is the cyclically adjusted P/E average [CAPE].

For the best part of the 15 countries that dominate the world, many are 30% to 60% below their long-term CAPE averages.

The equity risk premium at any particular moment is probably the best guide to how equities will do on a five-year basis. It is about double the average of the past 30 years, partly because of growth from the BRICs. With real bond yields so low, the equity risk premium is off the charts. That suggests to me that, over the next five years, the equity risk premium is going to come way back down again, and that can only happen if bond yields rise sharply or, more likely, equities do very well.

Observations from Jim O'Neill

On "growth markets": "If you wait until they get as wealthy as the G-7, the investment opportunity will have gone."

On China: "The past months' evidence strongly supports a soft landing…inflation is going below 5% next month. If what I have just said happens, Chinese equities will already have rallied quite a bit further."

On equities: "If the world grows close to 4% next year because of China and the BRICs and growth markets, and the Fed stays really friendly, you will need constant bad news to stop equities from going up."

On the yen: "We're coming up to a big reversal of the yen. When investors realize that the U.S. economy is not going to weaken further, markets will not want to own the yen anymore."

What happens to equity markets between now and year end?

There are three major issues of the day. The improvement in Chinese inflation is increasingly raising the odds that we go out on the upside. In the U.S., I am in the camp that assumes the super committee guys [in Congress] will cobble something together. That's good for the upside as well. In Europe, until you get a Greek default out of the way, people hang back. So two out of three suggest we break out on the upside. It is very difficult for the market to drop. There is just so much cash around, and people are so bearish. Stocks around the world will be 20% to 25% higher.

How do you invest when everything is so highly correlated?

It's very difficult. Ironically, China is not that correlated with the U.S., which is why investors should be more open to investing there. Secondly, one has to look at different financial instruments or really unique markets. We live in a world where everybody is paranoid and aware of what he can lose. To ultimately really reward your clients, you have got to stand away from many benchmarks.

Also, partly reflecting my own historic bias, the foreign-exchange market is a great way to get away from this correlated asset market stuff. Look at the Swiss franc over the past three months. It got to such an extreme level of overvaluation, it was obvious the Swiss authorities would do something to reverse it. And we're coming up to a big reversal of the yen. When investors realize that the U.S. economy is not going to weaken further, markets will not want to own the yen anymore.

What else do you like?

China, because the valuations are really attractive, and the momentum after a difficult 12 months is going the right way. Of the growth markets, I like Indonesia least. I'm not convinced it's changing as much as people think, and year-to-date, the market is still up. By definition, European financial stocks seem remarkably cheap, particularly in Club Med Europe.